Skip to main content
diversification.com
← Back to B Definitions

Bankruptcy filing

What Is Bankruptcy Filing?

A bankruptcy filing is the formal submission of a petition to a specialized court to declare that an individual or entity is unable to pay outstanding debts. This legal process, which falls under the broader financial category of corporate finance or personal finance, provides a structured framework for resolving financial distress. When a business or individual undertakes a bankruptcy filing, it typically seeks either liquidation of assets to repay creditors or a reorganization of its financial obligations to continue operations. The specific type of bankruptcy filing chosen depends on the nature of the debtor's financial situation and goals.

History and Origin

The concept of bankruptcy has roots in antiquity, but modern bankruptcy law in the United States began with the U.S. Constitution, which grants Congress the authority to establish uniform bankruptcy laws. Early federal bankruptcy acts in the U.S. were often short-lived and focused primarily on involuntary cases initiated by creditors against merchant debtors. For instance, the first federal bankruptcy law, enacted in 1800, applied solely to merchant debtors with cases initiated by creditors and allowed for debt discharges only with the agreement of a supermajority of creditors.10

Significant legislative milestones shaped the current system. The Bankruptcy Act of 1898, often called the "Nelson Act," established a more lasting federal framework. The current iteration of U.S. bankruptcy law largely stems from the Bankruptcy Reform Act of 1978, which introduced the modern structure of chapters for different types of debtors and expanded opportunities for individuals to seek voluntary bankruptcy relief, a concept that was relatively novel in earlier legal frameworks.9 This act also established dedicated bankruptcy courts as units of the U.S. District Courts.8

A notable moment in recent history illustrating the impact of a bankruptcy filing was the collapse of Lehman Brothers in 2008. The investment bank filed for Chapter 11 bankruptcy on September 15, 2008, in what remains the largest bankruptcy filing in U.S. history by assets, exceeding $600 billion. This event was a major catalyst in the global subprime mortgage crisis, triggering widespread financial panic and a significant drop in the Dow Jones Industrial Average.

Key Takeaways

  • A bankruptcy filing is a legal action taken by an individual or entity unable to repay their outstanding debts.
  • It typically results in either liquidation of assets to satisfy creditors or a reorganization of financial obligations.
  • Federal law, primarily Title 11 of the U.S. Code (the Bankruptcy Code), governs bankruptcy proceedings in the United States.
  • The type of bankruptcy filing (e.g., Chapter 7, Chapter 11, Chapter 13) dictates the specific process and outcomes for the debtor and their creditors.
  • A bankruptcy filing significantly impacts a debtor's credit history and financial standing, often with long-term consequences.

Formula and Calculation

A bankruptcy filing itself does not involve a specific formula or calculation in the traditional sense of financial metrics. However, the decision to file for bankruptcy often stems from an analysis of a company's or individual's financial state, particularly their solvency and debt burden. Key financial ratios and considerations that precede a bankruptcy filing include:

  • Debt-to-Equity Ratio: This ratio compares total liabilities to shareholder equity, indicating how much debt a company uses to finance its assets relative to the value of shareholders' equity. A high ratio suggests significant leverage and potential financial strain.
    Debt-to-Equity Ratio=Total LiabilitiesShareholder Equity\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholder Equity}}
  • Current Ratio: This measures a company's ability to cover its short-term obligations with its short-term assets. A low current ratio indicates potential liquidity issues, which can lead to a bankruptcy filing.
    Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}
  • Debt Service Coverage Ratio (DSCR): This ratio assesses a company's or individual's ability to cover their debt obligations with their available cash flow. A DSCR below 1.0 indicates insufficient cash flow to meet debt payments, a common precursor to default and potential bankruptcy.
    DSCR=Net Operating IncomeTotal Debt Service\text{DSCR} = \frac{\text{Net Operating Income}}{\text{Total Debt Service}}

These ratios help assess the degree of financial distress, which often precedes a bankruptcy filing.

Interpreting the Bankruptcy Filing

Interpreting a bankruptcy filing involves understanding its implications for various stakeholders. For the debtor, it signifies a formal acknowledgment of financial distress and the initiation of a legal process to manage or discharge debts. The type of bankruptcy filing provides crucial insight: a Chapter 7 bankruptcy typically implies a complete cessation of operations and liquidation of non-exempt assets, while a Chapter 11 filing suggests an attempt at debt restructuring to continue the business.

For creditors, a bankruptcy filing means that repayment of their claims will be subject to court oversight and a prescribed order of priority. Secured creditors generally have a higher priority than unsecured creditors, and common stock in a bankrupt company is often worthless.7 Publicly traded companies that undergo a bankruptcy filing may be delisted from major stock exchanges, although their shares may continue to trade on over-the-counter markets.6

For the broader market, a significant bankruptcy filing, particularly by a large corporation, can signal economic weakness, industry-specific challenges, or systemic risk. The ripple effects of a major bankruptcy can be felt across supply chains, financial markets, and investor confidence.

Hypothetical Example

Consider "Alpha Manufacturing Inc.," a company that has experienced declining sales and increasing production costs over several quarters. Despite attempts to cut expenses and renegotiate terms with suppliers, Alpha Manufacturing's liabilities have grown to exceed its assets, and it consistently fails to meet its loan obligations. The company's management, after consulting with legal and financial advisors, decides that a reorganization is the most viable path to survival.

Alpha Manufacturing Inc. proceeds with a Chapter 11 bankruptcy filing. This involves submitting a petition to the bankruptcy court, along with schedules of its assets and liabilities, financial statements, and a list of creditors. The filing automatically triggers a "stay," which temporarily prevents creditors from taking collection actions against the company. During the Chapter 11 process, Alpha Manufacturing's management continues to operate the business, but all significant decisions, such as selling major assets or incurring new debt, must be approved by the bankruptcy court. The company will work with its creditors to develop a plan of debt restructuring, aiming to emerge from bankruptcy with a more manageable financial structure.

Practical Applications

A bankruptcy filing has wide-ranging practical applications across various financial domains:

  • Investing: Investors closely monitor bankruptcy filings, especially for publicly traded companies, as these events can lead to significant losses for shareholders and bondholders. The Securities and Exchange Commission (SEC) provides guidance to investors on what happens when a public company declares bankruptcy, noting that common stock is often worthless in such scenarios.5
  • Corporate Finance: Companies utilize bankruptcy laws as a mechanism for debt restructuring or orderly liquidation. This can involve selling non-core assets, negotiating with creditors for reduced principal or extended payment terms, and developing new business plans to restore profitability.
  • Credit Analysis: Financial institutions and credit rating agencies use bankruptcy filing data as a key indicator of credit risk. A history of bankruptcy filings within an industry or by a specific company significantly influences credit assessments and the cost of capital for future borrowing. For instance, research from the Federal Reserve Bank of San Francisco has explored the risk of business insolvency and its implications for financial stability.4
  • Legal Framework: Bankruptcy laws provide a formal legal process for addressing insolvency, ensuring fairness among creditors and offering a fresh start for debtors. The U.S. Bankruptcy Code, codified in Title 11 of the United States Code, is the primary federal law governing these proceedings.

Limitations and Criticisms

While a bankruptcy filing offers a legal pathway for addressing overwhelming debt, it comes with significant limitations and criticisms:

  • Damage to Credit and Reputation: A bankruptcy filing severely impacts an individual's or company's credit rating, making it difficult to obtain future loans, secure favorable interest rates, or even lease property. For businesses, it can damage brand reputation and customer trust.
  • High Costs and Complexity: The bankruptcy process can be expensive, involving legal fees, administrative costs, and potential expert fees. The complexity of bankruptcy law, especially for corporate reorganizations, often requires extensive legal and financial expertise, adding to the financial burden.
  • Loss of Control: Debtors, particularly in Chapter 11 bankruptcy cases, lose a significant degree of control over their assets and business operations, as major decisions must be approved by the bankruptcy court. In Chapter 7 bankruptcy, a trustee takes full control of the debtor's non-exempt assets for liquidation.
  • Uncertainty for Creditors: While bankruptcy aims to provide an orderly distribution of assets, creditors often receive only a fraction of what they are owed. The outcome can be uncertain, and the process can be lengthy, delaying repayment. Academic research has highlighted that transaction costs can discourage out-of-court debt restructuring and lead to higher leverage and subsequent financial distress for firms.3
  • Ethical Concerns: Critics sometimes raise concerns about potential abuses of bankruptcy laws, such as strategic filings to avoid legitimate debts or the prioritization of certain stakeholders over others.

Bankruptcy Filing vs. Insolvency

The terms "bankruptcy filing" and "insolvency" are closely related but distinct concepts in finance and law.

Insolvency refers to a financial state where an individual or entity's liabilities exceed their assets (balance sheet insolvency) or when they are unable to pay their debts as they come due (cash flow insolvency). It is a condition of financial distress. A company or individual can be insolvent without having filed for bankruptcy.

A bankruptcy filing, on the other hand, is the formal legal action taken by a debtor (or sometimes by creditors) to declare insolvency and initiate a legal process under federal bankruptcy law. It is the legal procedure that addresses the state of insolvency. Therefore, while insolvency is the underlying financial problem, a bankruptcy filing is the legal mechanism employed to resolve it. An entity must be insolvent to file for bankruptcy, but not all insolvent entities file for bankruptcy.

FAQs

Who can file for bankruptcy?

Individuals, married couples, partnerships, and corporations can file for bankruptcy in the United States, provided they meet specific eligibility requirements under the federal Bankruptcy Code.

What are the main types of bankruptcy filings?

The most common types of bankruptcy filings for individuals are Chapter 7 bankruptcy (liquidation) and Chapter 13 (wage earner's plan). For businesses, Chapter 11 bankruptcy (reorganization) is the most frequently used. Other chapters, such as Chapter 9 for municipalities and Chapter 12 for family farmers and fishermen, exist for specific circumstances.

How long does a bankruptcy filing stay on my credit report?

A Chapter 7 bankruptcy typically remains on a credit report for 10 years from the filing date, while a Chapter 13 bankruptcy generally stays for seven years. This can significantly impact the debtor's ability to obtain credit.

What happens to a company's stock after a bankruptcy filing?

When a publicly traded company makes a bankruptcy filing, its common equity stock is often canceled and becomes worthless as part of the reorganization plan, as bondholders and other creditors have priority in receiving distributions.1, 2 While trading may continue, shares are typically delisted from major exchanges.

Can a bankruptcy filing be reversed?

Once a bankruptcy filing is made and accepted by the court, it typically cannot be "reversed" in the sense of being undone. However, a bankruptcy case can be dismissed if the debtor fails to comply with court orders or if it's determined that the filing was made in bad faith. In Chapter 11 cases, a successful reorganization allows the company to emerge from bankruptcy.